Nasdaq-listed Luckin Coffee, with around 3,700 stores in China, had the compelling tech-savvy investment story that attracts investors.
It’s a cashless coffee chain (only two employees per store) with shops outfitted like a kiosk for pickup – all orders are done through its mobile app. Each shop has multiple video cameras that monitor customers and employees and add to a “big data” pool, which the company says helps to drive cost efficiency.
Marco Li, portfolio manager at TT International, who visited the company last year and spoke with top management, noted at the time that the cost per cup has been more than halved in 2019 and that a shop reached break-even point around six months after opening.
He viewed Luckin in a broader sense as a business emblematic of China’s economy shifting towards a more sustainable consumption-based growth model.
Li did not invest in the company – which appeared to be on track to fan out globally and become the next Starbucks — due to his firm’s investment requirements based on free cash flow.
“With these exponential growth companies there is pressure on cash flow, so it didn’t pass our cash flow filter,” he said.
This week, Luckin’s share price crashed and trading was halted when the company revealed that its chief operating officer may have fabricated 2019 sales by about RMB 2.2bn ($310m).
Passive protection
Luckin’s collapsing fortunes means losses for investors who poured money into the company’s 2019 Nasdaq IPO.
At the same time, it highlights a key benefit of passive investment.
Passive funds that follow an index tend to take a tiny stake across a large number of index constituents, resulting in negligible impact if a company’s share price is walloped by an extreme event such as fraud.
Active funds, however, make larger bets and thus take bigger risks.
According to FE Fundinfo data, two retail funds in the Hong Kong and/or Singapore universe have Luckin in their top ten holdings: JO Hambro’s Asia ex Japan Small and Mid Cap Fund (4.5%) and the Schroder ISF Emerging Multi-Asset Income Fund holds Luckin bonds (1.67%).
Looking at all available funds globally, 218 products hold Luckin, according to Morningstar Direct data.
Of that number, 115 have a weighting of more than 0.05 to Luckin – and 91% of the 115 are actively-managed products.
Of the bottom 103 products – the lower exposure funds holding 0.05% or less – 70% are passive, either ETFs or index funds, according to the data.
Wing Chan, Morningstar’s director of manager research in Asia, concedes that passive funds take a smaller weighting and therefore smaller risk.
But small caps in particular have an elevated chance of binary results — either collapsing or explosive growth, perhaps even becoming the next Amazon.
“With passive funds, the investor misses out on the opportunity for big, maybe huge upside,” Chan said.
Taking a contrary view, he sees the Luckin fraud underscoring the case for active management – a fundamental, bottom-up investment approach and a well-diversified portfolio.
“This is a common theme across our [fund] medalists in Asia small cap,” Chan said.
Of course, it all depends on the investor’s risk appetite and investment horizon.
Small cap scrutiny
Small cap risks include volatility – sensitive balance sheets that cannot comfortably absorb shocks to the business – and lack of liquidity.
Li, from TT International, pointed out that more complexity comes from internet-driven operations in fast-growth companies.
“You have to be quite careful how any internet business pre-sells [the products]. They can do forward sale coupons which are very difficult to audit when they are in a virtual sphere [in the cloud as opposed to an in-store ledger].”
Luckin was first accused of fraud by short seller Carson Block of Muddy Waters, who has uncovered fraud in several Chinese companies in the past, including Sino Forest’s massive deception in 2011.
Most recently Block accused China’s Nasdaq-listed iQiyi, the “Netflix of China”, of fraud, prompting some analysts to cite lack of oversight and opaqueness as characteristics of Chinese companies.
Li, however, said scandals aren’t about geographic boundaries “but it’s more about a type of company with no profits, but strong growth, that people get attracted to.”
